In its October 2018 update to the World Economic Outlook, the IMF revised marginally lower its projections for China’s growth and inflation – growth over 2019-2020 is expected to moderate towards 6.2% per annum, while consumer price inflation stays anchored in the 2.4-2.7% range. Such an environment of modest growth and inflation places bonds in a sweet spot.
Figure 1: The China fixed income proposition
Source: IMF World Economic Outlook Database, October 2018.
Indeed, China’s growth slowdown, from 6.8% year-on-year in the first quarter of 2018 towards 6.5% in the third quarter of 2018, has been due mainly to policy-induced deleveraging onshore. While the intensity of the deleveraging process has eased somewhat, we believe the direction of travel will continue. From an external perspective, while the direct impact of US tariffs has yet to be seen in the hard data, we expect the impact to start coming through more meaningfully in 2019. Consequently, we see headwinds from both internal and external factors.
To offset these headwinds, policy has become more accommodative. On the monetary front, reserve requirements were cut three times in 2018 and there is significant room for further relaxation if required. Fiscal policy has also turned more supportive, most recently in the form of personal income tax deductions scheduled to take effect from 2019, with VAT and corporate income tax cuts likely to be next.
In this context, we think that onshore bond yields will remain well supported over 2019, and expect further interest rate divergence between the US and China.
The ratcheting-up of US-China trade tensions in 2018, coupled with slower domestic growth on the back of deleveraging, saw the Chinese renminbi (CNY) give up its early 2018 gains against the dollar to weaken another 6.5%. At almost 7.0 CNY to the dollar1, we think the near-term risk of significant renminbi depreciation is limited. The destabilising impact of further depreciation on sentiment would see the authorities act to support the currency, as was the case when it re-applied the counter-cyclical adjustment factor in August. Moreover, any further depreciation will only serve to worsen relations with the US and jeopardise chances of negotiation. Fundamentally, China still runs a significant trade surplus against the US. However, should the US press ahead with imposing 25% tariffs on all imports from China, there is a risk that the CNY may weaken somewhat to offset this.
More broadly, with its high domestic savings, little reliance on foreign financing, tight reins on resident capital outflows and improved policy coordination, China has meaningful domestic levers to support growth. Longer term, support for CNY ultimately lies in improved productivity and investment prospects in China – levelling the playing field between state-owned and private/ foreign-owned enterprises will be paramount in fully realising these objectives. To this end, the pursuit of stable growth conditions, economic transformation and continued market-oriented reforms are key.
Operational enhancements to ease foreign investor access mean that there is a good chance that Bloomberg Barclays starts including China in the widely followed Global Aggregate Index from April 2019. We think JP Morgan could start including China in the GBI EM Global Diversified Index in the second half of 2019, with FTSE Russell to follow with the World Government Bond Index.
If this comes to pass, it should provide significant inflows into the bond market over the next couple of years. Most estimates are in the region of US$250 billion-US$300 billion. 2019 could be the year where we see these index inclusions mainstream Chinese fixed income as a core allocation in global portfolios.
US dollar China bond yields have repriced with US interest rates higher and credit spreads wider. This is a healthy correction from tight levels back in 2016/17. Towards 6% at the aggregate level, we think that this is beginning to present attractive opportunities.
Figure 2: Repricing in US dollar China corporate credit
Source: JPM Asia Credit Index China Yield to Worst, 31.10.2018.
1 as at 1 November 2018.
Wilfred Wee: China bonds in a sweet spot
As part of The Big Picture Podcast channel, Wilfred Wee explains why modest growth and inflation in China place bonds in a sweet spot.
Investing in China: Investment in mainland China may involve a higher risk of financial loss when compared with countries generally regarded as being more developed.Listen to the podcast Subscribe to our podcast channel
Volatility in the Chinese equities market in 2018 has been driven by tightening domestic liquidity as well as escalating trade tensions with the US.
However, the long-term investment case for China remains clear and opportunities are emerging in this environment. If we look beyond short-term headwinds, active investors with a disciplined investment process should be able to find quality Chinese companies with good long-term growth potential and decent management.
Concerns about China abound, including a build-up of debt, negative demographic trends, state-owned enterprise inefficiency and general corporate governance risk. We recognise the challenges in all these areas. Yet, we should not ignore China’s ongoing transformation, which is being driven by government reform and innovation in the economy. This transformation addresses many of the concerns investors have and supports the development of the equity market over the long term.
Government reform efforts are happening on multiple fronts. Supply-side reform has nearly completed its third year, with capacity reduction targets well on track and even exceeding expectations in certain industries such as steel. Environmental control remains stringent, driving significant decreases in air and water pollution. State-owned enterprise reform is helping to align the interests of the state, management teams and public shareholders. Financial reforms continue to foster better risk control in financial institutions and a further opening of the domestic capital market to global investors.
With a large consumer base and growing wealth, China has seen increasing demand for higher quality products and services. Large numbers of Chinese go on shopping sprees abroad, which is driving domestic companies to innovate so that they can capture more market share. Good infrastructure and efficient supply chains provide the backbone for a more innovative China. An abundant and inexpensive talent pool, significant social capital and supportive government policy also play crucial roles.
An example of this is the World Intellectual Property Organisation’s Seven Pillars of Innovation, where China has generally performed in line or even better than the average high-income country, and is well ahead of what might be a more obvious comparator, the average for upper middle-income countries.
Figure 1: The seven pillars of innovation
Scale 0 to 100, higher score means greater capacity.
Source: World Intellectual Property Organisation, HSBC, Dec 2017.
Although more and more investors, both institutional and retail, are considering strategic allocations to China, they remain underweight despite moves to open capital markets and make investing in China easier.
MSCI is looking to quadruple China A-share weighting in its major benchmark indices from 2019, only one year after its initial inclusion, which is faster than the market expected. FTSE Russell will also start phased inclusion from June 2019, which will see China A-shares representing 5.5% of its emerging market index. If fully included, China A-shares should account for more than 16% of the MSCI Emerging Markets Index and more than 20% of the Russell Emerging Markets Index. China’s onshore and offshore markets together will account for over 40% and 50% of the two indices, respectively.
Given China’s strategic importance, attractive long-term growth potential, increasing index inclusion and diversification benefits, we think global investors’ allocation to the world’s second-largest equity market will grow over time. Increasing foreign investors’ participation should help reduce market volatility and improve pricing discovery in the A-share market.
We believe the market drawdown provides entry opportunities for fundamental investors and will reward them in the long term.
Following a significant pullback in 2018, the Chinese equity market currently trades below its 10-year historical average valuation level from both the forward price-earnings and the price-to-book perspective. The valuation discount versus developed markets has widened despite the more positive growth outlook.
Although we do not attempt to call the bottom without seeing evidence of positive surprises on corporate earnings, an increasing number of opportunities are emerging on the back of the market pullback. As more value emerges, we are finding opportunities in a number of sectors. The evidence suggests that companies with good quality, attractive valuations, improving operating momentum and increasing investor attention tend to outperform over the long term and this remains the framework for our stock selection. Our 4Factor screen currently sees most opportunities in the materials, energy, financial, utility, and communication services sectors.
Clearly, the Chinese equity market faces short- to medium-term, most significantly policy execution and growing trade tensions between China and its trade partners, particularly the US. Over the long term, we believe a consistent investment strategy focusing on identifying high conviction ideas, using a bottom-up approach, is the best way to provide long-term risk-adjusted returns to our investors. We remain broadly fully invested in our portfolio as there are abundant opportunities that can be found in a dynamic market environment such as China.
Our bottom-up stock-picking generates ideas from a broad range of sectors, covering both new and old economy segments. Fundamental analysis, combined with objective screening, will continue to drive new investment ideas for our portfolio.
This content is for informational purposes only and should not be construed as an offer, or solicitation of an offer, to buy or sell securities. All of the views expressed about the markets, securities or companies reflect the personal views of the individual fund manager (or team) named. While opinions stated are honestly held, they are not guarantees and should not be relied on. Investec Asset Management in the normal course of its activities as an international investment manager may already hold or intend to purchase or sell the stocks mentioned on behalf of its clients. The information or opinions provided should not be taken as specific advice on the merits of any investment decision. This content may contains statements about expected or anticipated future events and financial results that are forward-looking in nature and, as a result, are subject to certain risks and uncertainties, such as general economic, market and business conditions, new legislation and regulatory actions, competitive and general economic factors and conditions and the occurrence of unexpected events. Actual outcomes may differ materially from those stated herein.
In Australia, this document is provided for general information only to wholesale clients (as defined in the Corporations Act 2001). All rights reserved. Issued by Investec Asset Management, issued November 2018.